Explain covered bonds and what sets them apart from other asset-backed securities
The idea
A covered bond is a senior debt obligation of a financial institution, usually a bank, backed by a segregated pool of assets such as residential mortgages or public sector loans. Unlike a typical asset-backed security, the assets are not sold to a bankruptcy-remote special purpose entity: they stay on the issuer's balance sheet, and investors have dual recourse, first to the issuer and then to the cover pool if the issuer fails. The pool is dynamic, so the issuer must replace loans that prepay or become non-performing, and legislation typically requires overcollateralisation. Covered bonds are usually single-tranche rather than structured into senior and subordinated classes. Redemption regimes after an issuer default range from hard bullet, through soft bullet with an extension period, to conditional pass-through. The dual protection means covered bonds usually carry lower credit risk and lower yields than comparable ABS.
A practice question
If the issuer of a covered bond defaults, investors have recourse to:
- the cover pool only, via an SPEWhy not: Describes a typical ABS, where the SPE's assets are the only source of payment.
- the issuing bank only, as unsecured debtWhy not: Leaves out the cover pool, the segregated assets that back the bonds.
- both the issuer and the cover pool — correct
Dual recourse is the defining feature: a covered bond is a claim on the issuing bank, and the cover pool stands behind it if the bank fails.
A harder one
A mortgage in a covered bond's cover pool becomes non-performing. The issuer will typically:
- pass the loss to the bondholdersWhy not: Covered bond pools are dynamic, so the issuer must keep the pool up to standard.
- replace it with a performing asset — correct
- move the bond into a junior trancheWhy not: Covered bonds are usually a single class with no tranching to absorb losses.
The cover pool is dynamic: the issuer replaces prepaid or non-performing assets to maintain the required quality and overcollateralisation. A typical ABS pool is static.
The hardest tier
A covered bond's issuer defaults, and the cover pool cannot pay in full on the scheduled date. Under a soft-bullet structure:
- maturity can be extended, often a year — correct
- the bond pays on schedule regardlessWhy not: A hard bullet does not guarantee payment: failure to pay on the scheduled date is an event of default, with no extension period.
- it converts to a pass-through for lifeWhy not: That is conditional pass-through, which switches to paying as pool cash arrives.
A soft bullet allows the maturity to be extended, commonly by up to 12 months, giving the pool time to realise cash before a default is declared.
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